Dark clouds in forecast

Your long-term market assumptions may be all wet

CHICAGO (MarketWatch) -- Everything you know about your financial future could be wrong. That's not a statement on listening to predictions of a dire market crash or following some new theory of the "best" way to invest. It's about what you think you know about stock market returns and how you have planned for them in the future.

Paul McCulley, managing director at Pimco and author of the new book "Your Financial Edge," says that investors need to reshape their portfolios to reflect the returns they should realistically expect from the stock market for the next 25 years.

It's not the first time someone has suggested that market gains will be lower over the long haul, it's just the rare occasion when someone with so much influence in the industry and such a long track record of being correct as an economist has called for such a dramatic shift.

Most investors and advisers believe that stocks will deliver an annualized average return of about 10% over the long haul, with small-company stocks doing slightly better. They believe this mostly because of the widespread acceptance of research by Roger Ibbotson of Ibbotson Associates.

A few years back, however, Ibbotson started suggesting that the first 75 years worth of research would not be a good indicator of the next 25 years. Instead of 10% on large-cap stocks, Ibbotson said the next quarter century would see the market deliver somewhere in the 8% to 9% range, on average, most likely in the high end of the range..

McCulley, however, is saying that the last 25 years -- a period he described as "a long journey of disinflation" and "irrelevant" to the next quarter-century -- will have no bearing on the future.

McCulley went well past Ibbotson, forecasting a rate of growth in the range of 6% to 8% annually, and said that investors should "remember that it could be at the bottom of that range."

Rest assured that plenty of investment advisers and pros will suggest that McCulley is way off base. They'll say it because to do anything else blows a huge hole in their financial planning.

While it certainly is possible that McCulley is wrong, consider what happens if he is right.

The big matter of a few percentage points

Say your expectation has been set at 10% returns, on average, per year. Using a rough compounding formula, that means your current nest egg -- without any further contributions -- would double three times and be halfway to a fourth over the next quarter century. A nest egg of $100,000 at that rate of growth would be just under $1.2 million in 25 years.

Now cut those returns down to McCulley's predicted range. At 8%, the money doubles three times; at 6%, it doubles just twice. That same $100,000 in savings would be worth somewhere between $400,000 and $800,000. And living on that retirement nest egg would be one heck of a lot harder.

If you believe the studies which suggest that Americans are not saving sufficiently to fund the retirement they are planning on, and pile on the idea that returns on the money they are saving will come in below their expectations, you've got a major problem.

"You can't simply plan to get a 10% return because that's the number you need," McCulley said. "You must plan based on what you expect to happen in the market, and what you should expect is that the next 25 years won't be anything like the last 25."

That leaves consumers with some choices that McCulley acknowledged are ugly.

No good options

Some people will be forced to work longer in order to amass the money needed to get them through retirement. Others will be forced to reduce their expectations and downsize their retirement, giving up some of the comfort, hopes and dreams they could have if the market simply grew faster and did more work.

Finally, people can save more of their current income, which in McCulley's world moves from the "always good advice" category into the "can't live without it" column.

For consumers, McCulley's forecast should be a call to action, even if it doesn't automatically spur one of those results. It should prompt investors to review the assumptions they have made about retirement savings, to adjust their hoped-for returns downward and to see how the future looks if the market is muted for 25 years.

For investors who have a collection of funds, rather than a plan and a realistic expectation of growth for their investments, it's a call to set expectations reasonably and to then react to them by changing financial habits.

Nobody is going to like the message that returns are shrinking and that lifestyle changes -- sooner or later -- are coming, McCulley said, "but if you can't avoid it -- and I don't think you can -- you had better plan for it and react to it."

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